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Scott Gallacher

Special Counsel and Consultant, International Trade Group Inc

Scott Gallacher explains how to avoid the pitfalls associated with dividing pension pots upon divorce

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Scott Gallacher explains how to avoid the pitfalls associated with dividing pension pots upon divorce

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Considering that pension sharing has been in existence for almost 12 years I am always surprised at the lack of co-operation, formal or informal, between family lawyers and financial advisers when it comes to divorce cases.

Everybody now knows that pensions can be an important part of an individual’s assets and the most common treatment is offsetting or equalising the value. However, very many family lawyers and mediators simply use the value quoted by the pension scheme - the cash equivalent transfer value (CETV). However, CETVs are often not what they seem and taking them at face value is fraught with danger.

Family lunch

Over a recent lunch with a more enlightened family lawyer, she mentioned to me that she’d already spotted adverts in the Sunday papers from claims management companies encouraging divorcees to make a claim against their solicitor for failing to properly take into account pension benefits. Her view is that family lawyers should be addressing the pension issue much more carefully and consistently. As well as the wish to do the best job for their client, it is worth considering the cost of investigating and possibly paying out for future complaints…

The valuing of pension benefits can be extremely complex and is not an area that solicitors are normally qualified to give advice, particularly in the case of final salary pension schemes. The foremost factor is that final salary CETVs are invariably lower that the ‘fair value’ of actual pension benefits - often very significantly so. In Pensions on Divorce – Law, Practice and Precedents (Salter, Rae and Ellison, 2009), the point is made that: “There are separate valuations for various purposes… a cash equivalent valuation is yet another method of valuing pensions, which invariably gives the lowest value… It certainly would not be enough to buy an equivalent pension on the open market.”

This arises from the fact that there is no one definitive set of rules for valuations – rather a variable set of actuarial assumptions. The chief factors in these discrepancies are:

  • No credit is given for future continued membership of the scheme or that salaries tend to rise faster than inflation (this can be a very significant factor).

  • Future promotion (and associated salary increases) have the effect of increasing future and existing benefits. Ignoring this factor can dramatically understate the eventual benefits.

  • If the scheme is underfunded, as many are, the CETV is reduced accordingly whereas in practice, the member’s final retirement benefits are unlikely to be reduced unless the member transfers his benefits or the scheme is wound up.

  • Assuming a high, unrealistic, investment growth rate from now ?until retirement.

  • Not taking account of guarantees offered by the employer and the pension protection fund – which effectively underwrite the scheme (by contrast, transfers switch all of the investment risk onto the ex-spouse of the member.)

  • Assuming higher annuity rates at retirement than are currently available.

Case in point

I was asked to review a recent case where the husband had by far the larger pension provision: a money purchase ‘pot’ of £200,000 and a significant final salary scheme quoting a CETV of £200,000.

The husband’s solicitor had suggested a simple pension sharing order of 50 per cent of both which, on the face of it, sounded sensible. However, we were instructed by the wife’s solicitor to review matters.

First of all, a 50 per cent split on the money purchase fund would certainly have provided similar benefits to both parties – about £3,000 a year, index linked (by the end of this year the EU’s directive on insurance should remove any gender differences).

So far, so good…

But then our research discovered that the final salary CETV had been reduced because the scheme was underfunded. Even worse, this reduced CETV also failed to take into account that in a year’s time (aged 60), the husband could take an early pension of £10,000 a year – which would arguably require a fund of not £200,000 but over £300,000. I also calculated that his benefits at age 65 would require a current fund of around £400,000.

It’s clear in this case that a 50 per cent share based on the £200,000 CETV would have been hopelessly inadequate for the wife to purchase equivalent pension benefits. If the proposed split had gone ahead, the husband would have been able to take an early retirement pension of £5,000 a year while the wife would have been able to obtain only £3,000 (including the other pension, the overall picture would have been £8,000 and £6,000 respectively).

In terms of capital funds, this equates to a difference of around £67,000 – or much more if the husband had decided to retire at 65.

In this example, the proposal was clearly unequal, and a cynic might suspect deliberately so. But no. Had the husband’s solicitor deliberately intended to maximise benefits at the expense of equality, he or she might have proposed all of the money purchase funds to the wife and all of the final salary scheme to be retained – again, a £200,000/£200,000 split.

Again though, this is an illusion. In fact, this seemingly equitable split would have been much more unequal, with (at the husband’s age 60), benefits of £10,000 a year for the husband and only £6,000 for the wife.

Common pitfalls

This case highlights a really key issue that is very often overlooked by the unwary. However, there ?are several other pitfalls that crop up time and time again, including:

  • Guaranteed annuity rates. Many older pensions have guaranteed annuity rates of up to 11 per cent. With today’s low interest rates this can effectively double the value of the pension. This will normally be lost on any pension sharing, slashing the value of the asset.

  • Tax-free lump sums. Pre-2006 occupational pensions can offer tax-free cash amounts in ?excess of 25 per cent of the fund. This is often overlooked by both pension providers and members as the entitlement isn’t automatically offered by the provider.

  • Differences in spouses’ income tax rates. It costs ?a higher rate taxpayer just £60,000 to acquire ?a £100,000 pension fund, whereas it would cost a basic rate taxpayer £80,000 to acquire the same fund. If looking at offsetting pensions with cash payments it is important to take account of ?this difference.

In the case described above, because this is the ?real world, the wife in the end was unwilling to pursue the matter to court (against her solicitor’s ?and my advice).

However, as it was, our report ensured that she was at least made fully aware of the disparity. Not only that, but both solicitors arguably avoided a troublesome future claim for £67,000 or more by ?a claims management company.

The conclusion is that where pension valuations are concerned, it is usually in the interests of all parties to obtain an expert assessment by an actuary ?or experienced independent financial adviser. Of course, because of the extra costs, some clients will reject a recommendation to do so – but evidencing at least an offer of the service could go some way to reducing the chances of future problems.

Scott Gallacher is a director at Rowley Turton independent financial advisers. He can be contacted on scott@rowleyturton.com. For more information see  www.rowleyturton.com